Global Rates: Where next for CB and rates as the Middle-East conflict persists?

Hi and welcome to @NUrate, JP Morgan's global research podcast series. We take a look at some of the drivers behind the biggest trends and themes across fixed income, currencies and commodity markets. I'm Francis Diamond, head of European rate strategy at JP Morgan and today I'm joined with my colleagues, Jay Barry, head of international rate strategy and a DT Chordio to discuss the impact of the Middle East conflict on the US, Euro area and UK rate markets as well as the upcoming Fed, Buie and needs to be central bank meetings. So the past two weeks have seen pretty sizable sell off the yields as rate markets have priced in the inflationary impact on the spike's an oil and more particularly for Europe gas prices due to Middle East conflict and in addition, both in the Euro area and UK rate markets have been sizable, delivering of various outright and curve positions that have also added to it with pressure on yields. But maybe if we start with the US and Jay at the front end, it kind of followed suits for the moves seen in Europe and the UK. Two year treasury yields broke the range, they've held the last six plus months, money markets now pricing the Fed on hold through December and just one full 25 base point cut over the next year. So maybe you could explain what do you think has gotten us here. Thanks Francis and I think a number of the factors that you discuss with respect to UK and European rates are influencing the US as well. Down to the extent that the US is an energy exporter and to the extent that the Fed has a dual mandate on labor markets and inflation, we would think that US yields should be less sensitive to changes in oil prices and they have because the moves have been smaller than what you have seen. However, I think as a starting point, markets heading into this conflict have been pricing at 65 to 70 basis points of easing over the next one to two years and our baseline had been for the Fed to be on hold, but certainly as Bruce and the global economists wrote about just earlier today, Brent sitting close to 100 hours just generally makes central banks a bit more skinish on doing anything and point to more extended on hold. So I think that's being reflected in markets right now and further from that, I think there were some technical dynamics that have contributed to this as well. You talked about positioning and heading into March. We think there is a distinct long at the short end of the US curve for two primary reasons. The first is, I think there are still residual concerns over the labor market and even though private employment demand has been pretty stable for the last year and the unemployment rate has as well, we think given the divergence between capital expenditures and labor markets, there's still a downside pressure that market participants were worried about more fed easing, particularly because the second piece of the puzzle is related to Fed turnover and that most market participants think that Fed nominee Warsh will be able to bend the committee to his will when he takes the seat later this year and deliver the lower rates that President Trump has been advocating for. So from that perspective, we do think positioning contributed to this move as well, just like you talked about Europe and the UK and it wasn't just active investors who were positioned for easing Fed, but we think it was systematic as well because as Jason Hunter, our chief technical analyst talked about earlier this week, the front end of the US curve broke through a 200 day moving averages just yesterday and that probably set with it a shift in the CTA community flipping from long to fully short as well. And then finally fundamentals, we can't forget the inflation story that persisted prior to this crisis and this week we had two pieces of inflation data was just, I think, ratify the likelihood that the Fed should be unhold and hire front end rates. The first was quilly today's January PCE numbers, which core PCE rose 0.36 over the month and 3.1% over a year ago and then the CPI numbers earlier this week while it certainly was a low side 0.2 reading. The underlying composition indicates we're likely to get another 0.4% reading on core PCE for February as well, which is just leaving inflation at 3.1% through the month of February. So we think that also contributed to it, making it harder for markets to price and Fed easing. And finally, as we've seen, any time delivered volatility increases, there's been a liquidity component that has probably exaggerated this as well. And market depth in the treasury market has declined about 30% from its local peak, which is to be expected as valid creases. But I would just note that in these moves, the relative decline in liquidity versus other volshocks, say the regional banking crisis of 2023, the yen carried trade on wind in 2024, liberation day announcement last April. It's all been pretty modest. And I think that points to structurally better liquidity, which is in something we've been focused on in one of our recent pieces as well. So, combined this has gotten us to where we were, markets at the short end are more aligned with our Fed view for the first time in months. And I think that's why we are probably reaching this point where the front end is at least today, beginning to find a bit more stability as well. Okay, so if we think about Fed meeting next week, markets are pretty much pricing nothing as he's highlighted, what do you think we should be on the lookout for in terms of communication? And do you think there's anything that Fed can say next week that can influence US rate markets? No, that's a great question. And as you said, Francis, we're pressing in less than a basis point for next week. So, markets have acknowledged that it's unlikely that the Fed will do anything. But there's a few channels here to consider. I think first and foremost is the vote. And we know that at the last meeting, Governor Mayeron has descended like he had and Governor Waller descended as well. But we think in the context of Waller's recent comments that it's unlikely that he's going to dissent dubbishly for a cut at this meeting, which means that the vote will look a little cleaner and more alive and with a Fed on hold for the medium term. Secondly, we get a new round of projections from the Fed for the first time since December. And before the conflict began over the intermeeting periods, I think we would have expected to see an increase to real GDP and inflation forecast for this year and a lowering of the unemployment rate forecast. So I think this is also something that pushes the Fed in a less dubbish direction. But the last round of dots showed a single cut for this year and further normalization of the Fed funds rate in 2027. And when we look to the dots, we think it's a very close call for 2026. We think if we had to make a choice, the dots continue to show a single cut for this year that median dot continues to show that but it's a very close call while we would expect further normalization into 2027 as well. So if that's the case, I think with markets broadly pricing out for the Fed for this year, but still pricing Fed easing for next year, I don't think any of these factors are likely to be that influential on moving yields next week. And instead, we're probably going to still be at the mercy of what's happening with respect to energy markets and what's happening in the Middle East. But away from that, we also have this conference. And we think it's pretty likely that Chair Powell is going to have to spend a lot of time in the press conference, bobbing and weaving and avoiding questions about Fed succession. Now that this will be the first meeting we've had since Kevin Warsh was nominated as Fed Chair as well. We would also expect him to ratify during the press conference. If thesis that policy is very well positioned to deal with shock to neither direction right now and sort of the central thesis out of most central banks as well, which is one of patients that they're going to sit here, wait and assess the impact of the conflict on energy prices, on inflation, on growth before proceeding on the policy side. So if that's the case, pretty down the middle from our perspective and pretty aligned with where markets are priced over the next few months and over the next few years should that matter? Okay. I mean, I think that makes sense. And certainly the way that the approach in the current geopolitical uncertainty is probably the way central banks would react in the short term. And given those developments and how you see the Feds, if you look a little bit first further forward, if you look across the yield curve, how do you expect rates to behave going forward then? Yeah. So our central thesis when we published our 2026 outlook was that a Fed unhold was likely to result in a gentle move higher in rates and a cheapening in the along the belly of the curve. And clearly yields have moved substantially higher hair over the course of the past two weeks month to date. But it's been mainly a front end and a long end story. And as we just discussed, I think it's probably likely now that positions are cleaner that the front end should probably find a bit more stability here now that we've priced the Fed unhold firmly into the end of this year. But what's really notable, Francis, is that in this move, the intermediate sector and the five year sector has outperformed along the curve. So we have found over shorter horizons and longer that the five year sector tends to be very directional on the curve outperforming as markets price in a more dovish path for the Fed over the next one to two years and underperforming when the reverse happens. So interestingly enough, as we've backed up here, the five year sector hasn't really underperformed. And now on that basis looks about two standard deviations to a rich along the curve. So I think the risk is from here is the underperformance, which was really front end concentrated, which likely becomes much more intermediate concentrated. And that would align with our industry forecast, which certainly have intermediate yields continuing to move higher in the second half of this year as markets price the Fed unhold. Away from that, I think it's interesting to note, and this is something we've been focused for the rest of the day. weeks as well is that despite the moving energy prices, this has purely been a story about changes in front-end inflation expectations. And tips in the five to ten-year sector in the curve, break-evens there have continued to appear very cheap relative to their underlying drivers, which is macro factors like the slope of the money market curve, broad commodity indices, and risk appetite channel through the VIX. So I think it's tempting to say that there's room for long-term inflation expectations to move higher here, the longer this conflict persists. But at some point, if energy prices, if this upside risk that our commodity strategists have talked about come to fruition, then we flip this from inflation concerns and central banks on whole to growth concerns. So I think that makes us a little bit hesitant to think that break-evens can move materially from here, but we do acknowledge that they do look very, very cheap on that basis as well. Okay, thanks, Drake. So this year, let's shift over to Europe. We have the ECB meeting as well next week. I mean, given the focus on energy prices and the potential read across to inflation, what sort of message do you expect the ECB to deliver? And if we look at market expectations, there's a close to a full 25-based point high-capricized by July around about cumulative 40-based points of high-capricized by the end of this year. Do you think that is warranted in terms of market pricing? So, sure, Francis, like, yeah, I think that one thing, the easy part, the ECB is widely expected to stay on hold at the meeting next week, but the focus will clearly be on communication regarding the implication of rising energy prices on the back of the geopolitan Middle East conflict and also the ECB's reaction function on this whole inflation impulse coming from the conflict. So we expect them to move away in the communication from the good place narrative they had, at least till the last meeting, and then I've precise that the ability, they have the ability to act, they remain this stand ready to defend their mandate. And in our view, the ECB's staff assessment also would be of Iran war leading towards a hawkish direction, making it a bit of a more inflationary risk than a growth risk. Similar to analysis they had done in around 2020-23 Iran escalations. So as a result, we do not expect the ECB to push back much against a current market pricing and we expect percent laguard to emphasize uncertainty, uncertainty and say that the risk to rates have tilted to the upside and also stress the meeting to meeting approach. So I think it will be a much more message of their stand ready to act. And if things deteriorate further, they won't share away from hiking. On market pricing, as you highlighted, money markets are already pricing of full 25 basis went high by July and a 40 basis went cumulative by December this year, which is a very sharp turn around versus what we were pricing almost 10 basis points or so of cuts by late February. Although if energy prices stay around current levels, we see higher chances of the ECB staying home cold like our economists see inflation impulse of around 0.5 to headline OIA, which is not enough in our view for them to act, but clearly with the ongoing market uncertainty around the middle is conflict, it's very hard to push back on market pricing near term. Okay, so if we then think a little bit further out like how can you evaluate the impact of the conflicts on that say 10-year-old and entry me spreads? Are there any particular risk scenarios you're focusing on to be able to frame the risk profile? Sure, Francis, like what we did then now, weekly this week is like we publish our protections of German yield and in 20 spreads under different Middle East conflict scenarios. So we we looked at three broad scenarios, swift resolution of the conflict, sticky resolution of the conflict and to a long conflict. And these are very simplified scenarios I have to say. So the swift resolution scenario, which is a bit too optimistic in all honesty, like there's one where hostility ceases in a couple of weeks leading to a quick normalization of energy flow and prices to pre-war levels. If such scenario plays out, which as I said the reason developments don't point, don't make them quite unlikely. I think we can expect you know, rate market narrative to go back quickly to ECB firmly even hold and search for carry mode with will steepening of eels curves to remove the recent bare flattening or the tightening price of the front end and also in-term use spreads going back to the carry mode. So removing all the widening we've seen on the back of the recent risk of the two likely scenarios. The first one sticky resolution scenario is the one where it might take a couple of months to conclude the conflict, but even then the energy flow while the straight up removes is most likely to be hampered and not fully normalized for a while. And the energy prices although might decline from current elevated levels, but will still be may retain a higher risk, freemia and settle at levels settle at levels such as higher than where they were pre-war. So under this scenario, our economists will believe that the inflation shock at current level of energy prices will still be more greater than the one which I highlighted in the previous section. And we expect the ECB to hold rates at the current neutral level of 2%. However, the risk of them delivering at 25 to 50 basis point of insurance hikes cannot be ruled out in this scenario. And hence, we expect many market curves to price a modest front loaded tightening cycle. And based on our these projections, we believe short scenes could be around 230 versus current level of 240. And one yield to stabilize around 285 versus current level of 295. Also under such scenario, it will be linked with higher macro and rates volatility, warranting a wider infimus spread than the pre-war level. And we project 10/8-Lijamist spread around 75 to 80 basis point where we are currently at 80 basis point. The last scenario which we explored was a prolonged conflict scenario. And this is the one where the conflict directs on with the state of Hamuz is closed for a longer period of time, like we are thinking several months and that leads to a sustained elevated energy prices. I think about and oil prices above 120 barrel for a longer period of time. Such a scenario if sustained will be a large supply shock and lead to higher inflationary pressures, but will also progressively undermine growth via broad base supply chain disruptions and demand instructions. So over the near term, I think the market judgment which we see as reasonable would be to focus on the inflationary pressures leading to a stronger tightening response from the central bank which eventually might prove a policy mistake. So in such a scenario, we project more aggressive front-loaded tightening cycle, let's say 75 to 100 basis point of ice over the next six to 12 months. And then a flattening of money market curve further out. Such macro scenario might lead to large the fiscal response also because we are thinking about a sustained and higher energy prices which will require governments to sort of offset the pressure and the consumers by showing some fiscal response to the economy. And that will also add to let's say term premier risk on the German curve. So in this scenario, we pencil two years' hearts yield around 260 again versus 240 level now. And 10 year-bund yield at around 3% versus 295 level now. So overall, I think here it's more different than which we're moving higher. But the bund is already pricing this prolonged scenario with a higher probability. Also given the high in macro and policy uncertainty, we expect further widening of infimus spreads from current levels. And I'm projecting 10 year at least a spread around 85 to 95 basis point level. Again, a lot of uncertainty there because the long-awaited last writing could be even larger, but also it matters that what we do, policy response, both from the ECB and the European Commission. Overall, we find the current market pricing somewhere between the sticky resolution and the prolonged conflict scenario. And which doesn't necessarily look stretched even though ongoing developments. And we do not find the risk we were attractive in outright duration or in-train, you carry exposures at current level in the near term. What we have been saying, and I think the view hasn't reinforced by our scenario analysis is that if you are invested with a long term, that's surprising and a bit more risk appetite to which then near-term volatility. Current level of intermediate yields is quite attractive to lock for those portfolio. So Francis, that's for Euro area. We also have the BoA meeting next week, now in UK. And the markets have shifted from expecting a cut, like which we are always fully pricing a full cut at this meeting, to now expecting a no change from the BoE. What's the message that you expect the BoE will deliver? Do you agree with the 15 basis point of dating price by the end of this year now? Well, I think it's going to be very similar to what Jay mentioned for the firm and what you mentioned for the ECB in terms of a message that's relatively cautious here, taking to account the recent rise in energy prices. I don't forget the BoE was expected to ease rates at this meeting if you look back at market pricing a couple of weeks ago, and I think probably in our environment where the BoE will just be much more cautious about easing policy rates at the moment. I think they will see this as too early to be able to judge the scale and persistence of any likely inflation impact from the energy shock, just given the uncertainty around the conflict. I think also the BoE will have to evaluate whether it can look through elevated inflation that probably you'll be temporary and whether there's an auth sliders if you've got a highlighted in the area in terms of an increase in energy prices will eventually have an adverse impact on growth. I think it's too early to be in bank things and to really make any progress in terms of analysis or shifting an appetite direction. We expect the BUE to deliver a message that the increased uncertainty around the macro outlook just means they have very much weight and sea stance. But I do think it's possible the BUE will probably tweak the forward guidance statement and remove the language that currently says on the basis of current evidence bank rate will likely to be reduced further. By suspect, they'll probably still want to somehow keep an easing vast and the overall tone. But as you say, yes, market's pricing around 15 basic points of fakes by the end of this year. I mean, I think what is interesting is actually we've seen UK natural gas prices for modestly this week from their local peak seen on Monday. Yet frontends, GBP rates and stoning rates have continued to actually rise to price in this 15 basic points of tightening by the end of this year, which possibly is reflecting a little bit of the position, delivering that Jay mentioned as well. And I think in a short term inflation certainly you push higher, the NPC will be hesitant about how it thinks about a bump in headline inflation. But I think ultimately the Bank of England probably all things being equal still view policy rates at current levels of 375 is being restrictive. The UK laid market is still easing. So we do think it is possible the Bank of England could actually be easing rates maybe once or maybe twice more over the second half of this year if we're in an environment in which the conflict has de-escalated and there is some increased shipments through the spread of form moves and the price of the fallen. And there is a possibility, I think, still for the Bank of England to be easing in that scenario. 10-year guild yields and now hovering around 470. The highest level since last summer. Do you evaluate the impact of the conflict on 10-year rates? So I think we can take a similar approach to what you described in terms of scenarios. I think if you take those three you highlight it and go through them in order. If you look at a swift resolution, I think you can probably see 10-year yield falling back to around the 4.3% level, we're currently around 4.7 at the moment. I think under a sticky resolution with a sense that there is some signs of BUE potentially easing a second half this year, although with increased uncertain to your own inflation backdrop, I would pin 10-year yield somewhere around 445-450. I mean the more prolonged conflict, I think it's a challenging one as you already kind of highlighted and I think probably the initial response if you do see a significant and elevated more persistent spiking headline inflation would be a central bank in a BUE that's tightening policy rates, maybe just once 25 base points to 4% this year. But then I think the demand destruction channels, the growth uncertainty channels could then mean the bank will be easing back again, maybe they'll let's say 325/2027. So I think in that case, whilst the front end may well react, you could see higher front end rates, probably I'd expect a bit more of a flattening in the curve and potentially 10-year yields could actually be a little changed and maybe hovering around the current 470% level in that environment. Well, that's all from us. Thank you, Jay. Thank you Aditya and I think the messaging here is very much one of central banks that aren't going to be responding in the short term to the conflict and the spiking energy prices. And certainly when we look in in dollar space, probably the front end is more fairly valued. I think we take this scenario based view across Europe and probably lean a little bit more towards something that has a bit more of a bullish flavour, but I think we just need to see a little bit more geopolitics of roles before feeling comfortable in terms of shifting our views. Thank you for listening. Stay tuned for more updates on the fixed income space here on @anyrates. Jay Foggan's Global Research Podcast series. This communication is provided with information purposes only. Please read the Jay Foggan Research report related to its content, more information including important disclosures. Copyright 2026, Jay Foggan, Chase and Co, all right through there. This episode was recorded on the 13th of March 2026.